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UNIVERSITY OF THE PEOPLE

BUS 5111 FINANCIAL MANAGEMENT

WEIGHTED AVERAGE COST OF CAPITAL ANALYSIS

Dr. J. HALSTEAD

WRITTEN ASSIGNMENT UNIT 7

March 16, 2022

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A company that requires capital is evaluated by the minimum required rate of return, also known

as the cost of capital (Kenton & Drury, 2020). The company must be able to make more income

than the cost of capital used to fund the company’s operations (What is the cost of capital, n.d.).

The WACC is based on a company's capital structure, taken from the balance sheet where its

financing sources are listed (Carlson, 2020). They are weighted to determine the overall cost of

capital, called the weighted average cost of capital (WACC).

WACC Analysis – Current versus Revised Capital Structures

Current Capital Structure

Capital Stock Dividend Yield / Marginal tax Cost of
structure Capital Capital Weight Par Value Dividents Bond coupon rate rate After-tax WACC
Bond Capital
rate x (1- Weight x
formula Capital/ Total Dividends/Par value Tax Rate) Cost
Existing
Bonds $12,000,000 52.17% 5.00% 33% 3.35% 1.75%
Preferred
stock $5,000,000 21.74% $35.00 $1.75 5.00% not taxable 5.00% 1.09%
Common
stock $6,000,000 26.09% 10.00% not taxable 10.00% 2.61%
Total
Total $23,000,000 100.00% WACC 5.44%

Revised Capital Structure

Capital Stock Dividend Yield / Marginal tax Cost of
structure Capital Capital Weight Par Value Dividents Bond coupon rate rate After-tax WACC
Bond
rate x (1- Capital
Tax Weight x
formula Capital/ Total Dividends/Par value Rate) Cost
Existing
Bonds $12,000,000 36.36% 5.00% 33% 3.35% 1.22%
Additional
bonds $10,000,000 30.30% 4.00% 33% 2.68% 0.81%
Preferred
stock $5,000,000 15.15% $35.00 $1.75 5.00% not taxable 0.00% 0.76%
Common
stock $6,000,000 18.18% 10.00% not taxable 10.00% 1.82%
Total
Total $33,000,000 100.00% WACC 4.61%
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From the provided tables above, it is clear that the proportion of debt in the capital structure is

higher. The cost of equity is higher than the cost of debt. Since the interest is tax-deductible, the

after-tax cost of debt is further lower. Taking into consideration the lower cost of capital, the

+3company's performance will be better if debt is issued. On the other hand, when we consider

the current situation in terms of a liquidity shortage, it may be very difficult for the company to

obtain additional funding (Hill, 2014). The tax shield is the tax benefit gained by the company.

The current cost of capital, the cost of debt, and the cost of capital are equal. Since the

cost of debt involves expenditure incurred by the company while raising debt, and since interest

on debt is tax-deductible, it is wise to consider it seriously while determining the cost of debt.

The preferred stock dividend yield must be calculated by taking the dividend rate ($1.75) and

dividing it by the par value per share ($35.00), equaling 5.00% in both tables.

Looking at the second situation, the decision of management is to raise capital by issuing

public debt at a 4% coupon rate. The drawback to this decision is that regular coupon payments

will need to be made. However, the takeaway is that the business will still be controlled by

management and the company will benefit from the tax shield offered. Interest paid on bonds is a

taxable deduction for Comic Book Publication Group (CBPG), while the dividend payments are

not (Chen & Scott, 2020). To find the after-tax cost of debt capital, the bond’s interest expense is

multiplied by the (1-tax rate). The after-tax cost of capital for existing bonds is 3.35% in both

tables, and the additional bonds are at 2.68% in the revised table only. Since equity capital is not

taxed, or has a 0% tax rate, the 5% cost of capital for preferred stock and 10% for common stock

is not changed in the after-tax cost of capital column. Total WACC and Component WACC

To find the component WACC, in the last column, we multiply the weighted cost of

capital (third column) by the after-tax cost of capital (eighth column). The component WACCs
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are summed up to get to the current capital structure WACC of 5.44% and a revised capital

structure WACC of 4.61%. Since the capital weights decreased for the existing bonds and both

stocks, you will notice that their respective WACCs in the revised schedule also decreased.

When looking at the bonds, we see that the existing bond’s rate decreased from 5% to

3.35% after-tax and the additional bond's rate dropped from 4% to 2.68% after-tax. This is due to

the tax break on bond interest payments. Conversely, common stocks started at 5% and remained

at 5%. This is an example of why debt is less expensive than equity for a public company.

CBPG’s total WACC is currently 5.44%. Their revised total WACC was 4.61%, a 15.38%

decrease (see spreadsheet). This decrease is due to their increased leverage, with an additional

$10 million in bond debt, with an after-tax cost of capital lower than any other capital structure

components. All other capital components’ WACC decreased proportionally by 30.30%, which

is the additional bond's capital weight, as seen in the revised schedule

In conclusion, an increase in debt will increase the D/E ratio and leverage (Tuovila &

Drury, 2020), and generally, debt is less expensive than equity. However, there are limitations.

As a company becomes over-leveraged, the cost of raising additional debt increases. This is why

financial analysts perform sensitivity analysis, looking at different scenarios with their capital

structure, to determine the ideal mix of debt to equity and see how the changes will impact their

WACC. Based on this WACC analysis, we confirm that the CEO’s and CFO’s instincts were

correct and the additional bonds should be released with the decreased WACC of 4.61%. It is

also advised that they perform sensitivity analysis to determine their ideal capital structure and

WACC. Therefore, I would approve the decision to obtain additional funds by issuing corporate

bonds.
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REFERENCES

Carlson, R. (2020, June 29). What is the weighted average cost of capital? The Small Business:

https://www.thebalancesmb.com/calculate-weighted- average-cost-of-capital-393130

Chen, J., & Scott, G. (2020, March 9). Debt financing. Investopedia:

https://www.investopedia.com/terms/d/debtfinancing.asp

Finance for managers (2012). Licensed under a Creative Commons by-nc-sa 3.0 retrieved

fromhttps://my.uopeople.edu/pluginfile.php/546007/mod_page/content/17/

Kenton, W., & Drury, A. (2020, April 23). Cost of capital definition.

https://www.investopedia.com/terms/c/costofcapital.asp

Kenton, W., & Kindness, D. (2020, March 28). Sensitivity analysis.

https://www.investopedia.com/terms/s/sensitivityanalysis.asp

My accounting course (n.d.) Weighted Average Cost of Capital (WACC) Guide.

https://www.myaccountingcourse.com/financial-ratios/wacc

Tuovila, A., & Drury, A. (2020, July 14). Capital structure.

https://www.investopedia.com/terms/c/capitalstructure.asp

What is cost of capital? (n.d.).Corporate Finance Institute.

https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/